Credit Is Given

Indebtedness (and its discontents) is as old as human nature.

Jay Weiser

March 5, 2012, Vol. 17, No. 24

Doomsayers have denounced consumer debt for decades. But today, for the first time since the 1930s, consumer chickens have come home to roost, with a debt crisis in the housing markets and a looming student loan debt disaster. Debtor Nation digs through a century of trade publications and government documents to offer an

institutional history of the business-government interaction that created our current, massively over-leveraged consumer debt system.

Unfortunately, Louis Hyman’s moralizing gives him excessive faith that, after a century of perverse consequences, government regulation will magically develop the ability to steer credit appropriately. He starts with a distortion that reflects his limited understanding of finance: Before the 20th century, he says, consumer debt was unprofitable. In fact, it was profitable, but bundled. Strapped consumers—whether Victorian factory laborers or today’s white-collar workforce—have always sought loans to cover the gap between cash on hand and their need for goods. Going back to ancient times (according to David Graeber’s Debt: The First 5,000 Years), most consumer lending was store credit, recorded in account ledgers, but without an explicit interest charge. (Newt Gingrich’s no-interest Tiffany charge account is a survival of this earlier practice.) The retailer’s profit was the cost of goods plus the implied cost of credit, less bad debt chargeoffs. The key 20th-century change was unbundling: Rapidly falling information costs created a consumer lending market separate from store credit—which fueled a massive consumer economy while creating new systemic risks.

Hyman notes that stand-alone consumer lenders existed before the 20th century, but following popular usage, demonizes them as “loan sharks.” His evidence on the late-19th-century Minneapolis pawnbroker John Mackey—a key figure in the transition to 20th-century consumer credit as the founder of Household Finance Company—indicates that the market, rather than rapacity, was at work. Mackey faced high information and processing costs for pre-computer-era small loans; his financially stressed clientele had a high default rate; and low usury law ceilings made it illegal for him to collect market interest rates, thus encouraging a higher default rate. Therefore, despite charging usurious interest rates of up to 300 percent a year, Mackey’s annual profits in various lending offices ranged from 3.3 to 16.6 percent a year—a modest return for a high-risk business. When usury limits loosened after World War I, small consumer loan rates dropped to around 45 percent a year, but Hyman observes that lender annual returns remained similar, suggesting that the usury laws caused the astronomical rates.

Like early-20th-century reformers, Hyman sentimentalizes borrowers as needing cash only for noble purposes: tiding over a spell of unemployment or buying shoes for a child, rather than funding reckless spending or compulsive gambling. His later evidence suggests otherwise. After accounting for defaults, inner-city consumer durable retailers in Washington, D.C., for example, made only modest profits on their draconian installment sale contracts even before their deadbeat clientele, rioting after Martin Luther King’s murder, torched their records and looted their stores. (Washington’s 14th Street is only recovering four decades later.) And in a preview of today’s Federal Housing Administration meltdown, the Johnson/Nixon-era FHA Section 235 mortgage guarantee program for low-income borrowers with minimal down payments—an early “ownership society” effort—soon collapsed in fraud. Hyman, wearing his ideological blinders, blames “realtors, builders, home inspectors, and mortgage bankers [who] colluded in unsavory ways to defraud trusting first-time buyers.” He thus downplays the tradeoffs inherent in consumer debt: Wide availability creates risks of adverse selection (people eager for high-rate or low-down-payment loans are more likely to have trouble paying them) and moral hazard (greater borrower protections equal greater temptation to stop paying the debt), but tight regulation effectively rations credit by cutting off high-rate, high-risk credit for some people who could manage it.

Stripping away the moralizing, Hyman shows that the 20th-century expansion of consumer debt was driven by the drop in the price of consumer capital goods as a result of mass production, and by steadily rising incomes that made them affordable if consumers could pay over time. Twenty-five years before Keynes’s General Theory, Henry Ford introduced a business proto-Keynesianism, priming the pump to expand his production by offering consumer financing for his Model Ts. Other consumer durables manufacturers followed: By the 2008 meltdown, General Motors Acceptance Corporation and General Electric Capital Corporation were so huge that they posed systemic risk.

After World War II, a government fearful of a return to the Depression applied Keynesianism to housing. Engorged New Deal loan guarantee programs, subsidized interstate highways, and the mortgage deduction generated a suburban housing boom and debt-fueled lifestyle that required the middle and working classes to finance cars, furniture, and appliances. Even now, many economists wistfully hope for housing to return as the driver of the American economy.

Hyman fails to understand the proto-Keynesian implications of his argument. The credit card debt expansion of the 1980s, he claims, created no new investment, unlike loans made directly from banks to businesses. In reality, as increased consumer debt boosted spending, manufacturers would naturally expand their production capacity. The consumer debt boom’s other key driver was the massive drop in information costs starting with 19th-century railroads, telegraph, and printing technology. Using new technologies such as card catalogs, Charga-Plates, and Addressographs, local agencies provided credit reports for individual borrowers within a city. As databases became automated, today’s nationwide credit agencies developed. By the 1990s, computerization advanced, and bank-issued consumer credit cards became universal.

Not only did computerization allow better assessment of individual borrowers’ credit risks; it sliced consumer credit card and mortgage debt into AAA securitized bonds and riskier segments. This let lenders sell the bonds into the public markets, freeing up their capital for new loans—and in a harbinger of moral hazard, minimized their due diligence, since the bondholders now bore the primary risk of consumer default.

These innovations massively increased consumer debt, starting in the 1970s, just as the underpinning of the postwar debt expansion—lifetime jobs with rising incomes for white males—eroded. European and Asian competitors ate away manufacturing jobs, while white women and African Americans gained access to higher-quality jobs previously reserved for white males. High-income upper-middle-class feminists demanded equal access to credit, but the egalitarian spirit of the time (plus a desire to undo the legacy of segregation on the cheap) led equal access to credit to be framed as a civil rights issue, regardless of ability to pay. While African Americans and new Latino immigrants might have been better off saving in order to build their wealth, they were encouraged to borrow, despite tendencies to carry more debt at higher rates than other groups. As the decades went on, the pressure increased to extend credit to unqualified minority borrowers: on banks through the Community Reinvestment Act, and on Fannie and Freddie through congressional squeezing. (To be sure, the financial services industry was perfectly happy to make reckless subprime loans on its own.)

Perversely, the 1986 Tax Reform Act’s effort to lower the top income tax rate fueled both the late 1980s housing bubble and the 2000s mega-bubble. The act eliminated the deductibility of credit card interest but kept it for mortgages, even including second mortgages (now revolving credit lines styled as “home equity lines”). This encouraged consumers to use their homes as ATMs through increased leverage, removing most lending discipline. Given the Fannie/Freddie-implied federal guarantee, and bipartisan fealty to the “ownership society,” lenders made increasingly massive bets on housing.

The relentlessness of the debt expansion had consequences beyond the current bust, although Hyman does not address them. After 1970, debt-fueled consumer spending provided less proto-Keynesian stimulus to domestic production and employment. In manufactured goods, it increased demand for imports and foreign employment. Even housing production, the vaunted motor of the American economy, disproportionately created low-skilled domestic construction jobs for a huge influx of undocumented Latino immigrants. For higher-skilled housing financial services workers, such as real estate brokers, mortgage brokers, and investment bankers, government-subsidized house-flipping created an explosion of new jobs with huge bubble-era compensation that was pure waste.

Hyman argues that, over the past century, each wave of regulation has had perverse consequences—and has driven the next wave of innovation to get around it, resulting in still more consumer debt. His solution, however, is more regulation to steer credit in socially desirable directions. Rather than steering credit, we should consider rationing it again. While usury laws created an illegal loan-sharking industry, they also discouraged many financially distressed consumers from hopelessly overextending themselves. A modern equivalent might be to require a minimum 20 percent loan to value on home mortgages, including home equity lines.

Debtor Nation’s real lesson—although not the one that Hyman draws—is that public policy should not subsidize consumer leverage, whether through mortgage guarantees, mortgage interest deductibility, or too-big-to-fail lenders.

Jay Weiser is associate professor of law and real estate at Baruch College.